Tuesday, August 17, 2010

First a Tragedy, Now a Farce

Today's WSJ has an interesting article by Edward Pinto on the current housing mess. Basically, politicians still think they can have their cake and eat it too, subsidizing new homebuyers at rates that guarantees too much housing. What is 'too much'? That which is unsustainable. The 3.5% down mortgage that dominates the under $250k market is almost solely a government creation. As it says in the article:

In 1990, one in 200 home purchase loans (all government insured) had a down payment of less than or equal to 3%... Columbia University's Charles Calomiris to increase minimum down payments by 1% per year over 15 years, bringing them back to 20%, where they had been for decades.

Charles Calomiris was a professor of mine at Northwestern, and he is an expert on economic history, as well as how finance relates to business cycles. This is only natural because you discover quite quickly that the history of economic busts is that of financial panics. His proposal is considered extreme, highlighting the current insanity.

Anyway, to see how we got here, note that many are trying to say that the housing crisis was created by one blade in the supply-demand scissor: greedy bankers. Now, this is really rich because bankers--paradoxically to some--have suffered most, much more than the poor family that put up almost nothing to live in a nice house for a couple years. The Fed and otherwise intelligent Ben Bernanke would like you to believe the Community Reinvestment Act (CRA) had absolutely nothing to do with the 2007 housing crisis. Barry Ritholz went so far as to offer a $100k prize to someone who can 'prove' it caused the crisis, and Paul Krugman argues it had nothing to do with the crisis.

These are often semantic debates. I don't think the CRA caused the crisis, as in if the CRA legislation had not existed the crisis would not have happened. Yet it was symptomatic of the mindset that led to the crisis. The zeitgeist suggested that lowering underwriting criteria for homeowners was costless, turn renters with their various social and economic deficiencies into homeowners with their various social and economic proficiency, and be morally just. The mindset that underlay the CRA, not the CRA itself, caused the housing crisis. The CRA was joined by the Fair Housing Act and other explicit legislation. The regulators from the OFHEO, OCC, FDIC, SEC, and Federal Reserve were all on board with the tactics consistent with the strategy, meaning that bankers weren't criticized for lowering their standards in regards to home lending, but rather congratulated. The US Department of Housing and Urban Development, and Department of Justice had similar objectives and initiatives to those in the CRA. The CRA, in this context, was unnecessary.

Consider what was being argued before it became patently obvious that you can have too much of a house. In the National Housing Institute Journal, which contained a lot of economics and social justice (funny how these are conflated when convenient), Gregory Squires wrote in 2003:

And the Community Reinvestment Modernization Act would likely not have been produced if it were not for the advocacy efforts of the National Community Reinvestment Coalition, ACORN, the National Training and Information Center and community organizations around the country.

Saul Alinsky argued that there are no permanent friends or permanent enemies. And there are few, if any, permanent victories. Progress has been made in fair lending and community reinvestment, but that progress is threatened, as the rise of predatory lending in recent years demonstrates. Homeownership may be at record levels today, but low-income and minority neighborhoods remain underserved. Future goals for community reinvestment and fair lending seem reasonably clear, as do the tactics and strategies for achieving them. Sustaining the type of efforts responsible for past victories and required for future ones remains the challenge of the day.

A course on Community Development at the University of Buffalo lays out the housing strategy as part of what is true and good, and gives a grading scale with precision to the second decimal, as if the idea to redistribute via housing subsidies hidden within mortgages is so obviously true, we are just concerned about the decimals in any academic work in that subject.

In The Future of Community Reinvestment, Occidental College Poli Sci professor Peter Dreier lays out the conventional wisdom before anyone tried to lay blame for the insanity that peaked in 2006. Here are some of Dreier's Seven Key Ingredients to Community Reinvestment in 2003, which celebrated the housing bubble trends (he's being sincerely laudatory of all these trends):

Ingredient 2:

Activists pressured banks to invest more money in specific urban neighborhoods...Under pressure to channel credit into redlined neighborhoods--and to co-opt protects from community organizing groups and win favor with regulators and politicians--banks forged partnerships with community development corporations. for the most part, protest groups shook the money tree, and CDCs collected the rewards.

Ingredient 4:

Within a decade after the CRA was enacted, many banks created separate "community reinvestment" divisions. these divisions were often staffed by liberal individuals who sympathized with the aims of the community reeinventment movement. Indeed, some of these individuals had themselves been community activists who were recruited by banks to serve as liaisons with community groups.

Ingredient 5:

The movement's organizing strategy gave residents a clear set of remedies at the national, state, and local levels that went beyond neighborhood organizing... through the National Community Reinvestment Coalition, they worked with other groups to pressure Congress to strengthen the CRA and HMDA.

Ingredient 6:

By requiring banks to meet community needs as a prerequisite for obtaining various approvals from federal bank regulators and by giving consumer and community groups the right to challenge these approvals, the CRA provided these groups with leverage to bring banks to the negotiating table.

Ingredient 7:

Local groups working on the same issue were able to learn from one another. This learning occurred through several national organizing networks and training centers, particularly National Peoples Action, ACORN, the Center for Community Change, and the National Community Reinvestment Coalition.

The paper ends with a plea:

We Need a Progressive Agenda: the community reinvestment movement is part of struggle to make access to capital more democratic.

Dreier is unrepentant, arguing in the many posts online that ACORN has been unfairly demonized, and that the housing crisis had nothing to do with his earlier proposals for meeting loan quotas irrespective of standards. People at ground zero in this crisis who have been insulated from its direct effects--academics, wonks, politicians--have learned nothing from this conspicuous failure between theory and reality: the old 20% down payment was not arbitrary hatred of black people, it was merely prudent lending. Markets abetted the housing crisis as investors were co-conspirators with everyone else, but at least they learned a lesson. Clearly politicians have not learned and want to continue the madness at 3.5% downpayments forever. It's not sustainable.

Barry, Barry, I think you've painted yourself into an intellectual corner. The pat explanation that the CRA did it is wrong, but the opposite, that the housing politics was not merely insignificant, but orthogonal, is also wrong.

You claim that those claiming housing politics created the crisis are driven by politics, so the circle is complete. Isn't it strange how debates usually converge to a point where both sides accuse the other of, at a deep level, the same thing, be it short-sightedness, demagoguery or intolerance? I think it's useful to note the motives, in that as everyone in the financial industry moved their debt/income ratio and down payment criteria, they were being cheered by academics, nonprofits, regulators, and politicians who thought this was consistent with social justice. Politics didn't lean against this crisis, it aggravated it. The lack of a year-over-year aggregate housing price decline of significant magnitude provided the other leg to this stool, which did not stand very long.

Your 20 point explanation highlights your problem. Each point is kinda true, so the sum is some sort of Law of Large Numbers proof? No. The Talmud notes 'when a debater’s point is not impressive, he brings forth many arguments'. A diagnosis of the rise and fall of Rome based on 20 factors isn't even wrong, and so is your housing thesis.

Given that the US housing bubble was smaller by many measures than those in many other countries (Ireland, UK, Spain, Australia for starters), it would seem more likely to find reasons in what these countries had in common than in the US-specific programme under discussion.

Posterior beliefs: Do-gooder racially conscious liberals suck, while markets create something close to the best of all possible worlds.

Come on now. To be fair, Eric writes: "Markets abetted the housing crisis as investors were co-conspirators with everyone else, but at least they learned a lesson." But I don't think this adds up to a very large shift in worldview.

Under the "CRA theory of the financial crisis," the government strong-armed banks into making bad loans... only to watch the entire financial system eagerly devour such loans and demand more and more of them. Of course, as Eric has said many times, investors had no way of predicting the housing bubble. Fascinatingly, underwriting standards had been devastated by ACORN and Saul Alinksy but investors had no way of knowing this. Basically the idea is that political activists are destructive while market participants are following inexorable laws of nature, so whenever anything bad happens you have no choice but to blame the political activists, it's just basic logic see.

At least Eric has not succumbed to the view that investors made all these bad investments because they were terrified of being called racist (see Stan Liebowitz).

Eric, as a conservative you always have a choice when it comes to describing the efforts of the champions of social justice: you can classify their activities as counterproductive or merely futile. Let's circle back to 2005 or so, and say some community activist points to high rates of homeownership in minority communities, and claims this as a victory of social activism and proof of the power of progressive politics. What do you say to him?

Is it: "Yes sir, community activists are true forces for positive change in the world."

Or is it: "How naive, the banks made these loans because they wanted profits, let's give the credit to where it really belongs, to crafty Wall Street financiers who are normally dismissed in the popular press as being greedy leeches?"

Or do you just wait 5 years to see how everything turns out, because there's no way of determining causality unless you know if the outcome is good or bad?

hmm. With hindsight, I hope I would have said "this is unsustainable, and many of these homeowners will default on their mortgages, causing them to lose the home they are getting for almost nothing, and for investors to lose a lot of money".

The fact that investors too, made this error I think can be explained by any bubble, where some new fad comes along and is thought different (tech, railroads). Most investors believed in the same thing the do-gooders believed. Indeed, justice is generally consistent with how we think the world actually works, in that one would not think lowering underwriting standard was just if you did not also believe they were arbitrarily too high. This assumption was wrong, not everyone made it, but many did.

S - what did the UK have in common - well Northern Rock (the first Bank to go under IIRC) was offering upto 125% mortgages. Hell I got my first house on a 105% mortgage - bought at 66k in 2002 sold at peak in 2007 for 120k. Moved to Canada in 2009.

Also how important or relevant is/was being able to just walk away from the debt. Not able to do that in the UK, as far as I recall, you are on the hook for the difference after the foreclosure sale.

Eric, well done as usual. You always bring intellectual rigor to the debate without the political spin. Unlike many others...

Until recently, I was a career senior Examiner at the FDIC and had a front-row seat to how the FDIC failed to hear the siren call by many examiners in the field as the crisis too hold. The only explanation for this is the politics at the top of the agency, ... unfortunately a remnant from the prior Chairman of the FDIC, Donald Powell. Mr. Powell can be blamed for limiting the role of the FDIC, causing it to be to a much less effective regulator as the financial crisis took shape. While Chairman Bair is a highly regarded communicator and is heralded as being very consumer-oriented, much of this is "showmanship" with little substance. She cares much more with giving speeches than with remaining in her office and providing leadership and organizational reform. Every one of the executives hand-chosen by Don Powell remain in their key positions. Therefore, it should be little wonder why the FDIC was behind the 8-ball during most of the crisis.

I can tell you that politics has played a key role in many banks getting favorable treatment by the FDIC. If Congress or the public knew half the story, I am afraid that the FDIC would fare no better than the OTS. There ought to be an investigation taken up by the Justice Department not only on OneUnited Bank, but on the "skulduggery" by the agency relating to a host of other banks, such as Wachovia and Washington Mutual, Indy Mac, National City, Corus, and Citigroup.

The best way to clean-up the agency is to secure a safe channel for the flow of evidence by implementing whistleblower protection rights for current and former federal regulatory employees. Until that time, sadly there will continue to be costly bureaucratic cover-ups by top regulatory personnel. In the meantime, keep up your excellent reporting since the public can only help but get angry and finally seek real reforms from learning from your work. The Dodd-Frank bill does not address any of the issues of real regulatory reform as most informed observers know.

Could you briefly give your take on the non-U.S. housing bubbles? What you write above -- that government efforts to extend mortgage credit to marginal borrowers aggravated the housing bubble -- makes sense, but what about the housing bubbles elsewhere that occurred at the same time?

The estimates I have seen of the total unpaid subprime mortgages are between 0.3 and 1.0 billion dollars. The American financial system can easily absorb this loss, or to use Rev. Bacon's expression, investment in tranquillity.

The responsability for how and why this smallish socio-financial issue caused a worldwide panic and recession rests on the shoulders of the habitual financial geniuses. They should be hanged but not for excess greed but criminal incompetence. Hanged in effigy, may be.

There seems to be a bit more to the story about OneUnited Bank that's come out in the last day and that maybe Maxine Waters's grandson was the one who was overreaching. Hard to say. What seems wrong with this whole situation is that the FDIC was apparently clueless about the extent of the family investment in the bank. If they had been aware, would the conversation have taken a different direction? If I were Ms. Bair, I'd have the FDIC staff scrub every financial disclosure form of every elected official in the Congress and be sure that it knows any elected official or family member who owns equity in any insured institution. This does not exonerate Ms. Waters or her staff but it makes the FDIC staff look a bit amateurish. I wonder if the FDIC data base would allow for a search for the identity of shareholders of all banks with an ugly Texas Ratio.

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The responsability for how and why this smallish socio-financial issue caused a worldwide panic and recession rests on the shoulders of the habitual financial geniuses.

Well you might think that. But what should we do? Change the "culture" of Wall Street? Improve the moral fiber of bank CEOs? As our clear-sighted and completely apolitical friend Eric would tell you, this is naive and foolish. Wall Street is about one thing, making money. That's the one thing that counts. The desire for profits cannot be denied.

Oh, unless you're talking about an ideology of wanting to increase minority homeownership. Then before you know it AIG will blow up, investment banks will go out of business, and the entire globe will plunge into recession. Ideas are terrible, terrible things; do you know how much suffering Saul Alinsky has caused, more than 30 years after he died?

I enjoy Eric's writing very much but on this issue he seems to have decided that since booms and busts are basically inevitable, we can only assign real blame to ideas and actors that he finds politically disagreeable. The financial crisis strongly suggests that markets may only be self-regulating on a time scale that most people are not very comfortable with ("in the long run we are all dead"), but somehow the big takeaway is that the Democratic Party sucks (oh, and George W. Bush too, for fair-mindedness' sake), which oddly enough is exactly what people thought before.

This is the usual case of confirmation bias that afflicts everyone, but I really get the idea that Eric believes he is rising above politics with this stuff.

With hindsight, I hope I would have said "this is unsustainable, and many of these homeowners will default on their mortgages, causing them to lose the home they are getting for almost nothing, and for investors to lose a lot of money".

Eric, but what if it turned out that it was sustainable? Would the community activists then get credit for the increase in minority homeownership? If they get a share of the blame when things go bad, do they get a share of the credit when things go well?

I get the feeling this is a heads-you-win, tails-I-lose issue. The power of community activists to change the world only becomes evident when things go to hell.

Whether or not it was sustainable was apparently fundamentally unknowable until the bubble popped, so I see no reason to be especially critical of community activists for their actions before this time. We should hold them to a lower standard than investors, not a higher one.

By the way, if it had been sustainable I'm highly skeptical that you would be singing the praises of ACORN now. I'm much more of an ideological liberal than you are and *I* would have given the lion's share of the credit to financial innovation. If an activity can make someone rich, ideological motives seem rather irrelevant.

I'm still curious about Spain's real estate bubble, which occurred without ACORN, the FHA, Fannie & Freddie, etc. (Did Spain have similar institutions? Or did the cause of its bubble have nothing to do with affordable housing policies?).

I really don't know anything about Spain, what their underwriting criteria are or were. If their underwriting remained constant over the past 10 years, this would indeed be somewhat puzzling. However, given the US mortgage collapse tainted investment demand for all housing, perhaps the simple story is that investors errored by labeling all mortgages as the same regardless of underwriting going up, and going down.

I think the problem was that folks saw rising real estate prices as the way to affluence. CRA and other pressures for easier mortgages followed from that. A mechanism to prevent big gains from real estate ownership could have avoided that, as well as reduced taxes on actual productive activity, thus opening a way to real affluence.